Paniyiri has come and gone but in Greece the problems remain…

I thought it timely to provide some insights on global markets. There has been much activity lately relating to events in Europe. The direction global markets take from here very much depends on Europe’s determination to contain fallout from a potential Greek default.

The media is painting a very negative picture generally however first we should step back and look at the bigger picture. Signs are that the US economy is still slowly improving. Unemployment rate continues to fall:

And the housing market is showing some good signs of stabilising:

Likewise the picture in China is better than the newspapers would have us believe. Inflation is easing which is good and allows the Chinese government plenty of capacity to stimulate the economy if it slows down more than expected or desired:

This bodes well that if things do get worse in Europe the two largest economies have plenty of options available to stimulate and limit the fall out. Hence I would argue that the global the picture is relatively positive especially in the medium term.

Over the last week however we have seen the latest round of sensational headlines and further market corrections. This is of course related to what is happening in Greece and more recently Spain. The chance of a Greek Euro exits has grown and hinges on the upcoming Greek elections. The polls indicating a likely outcome are changing regularly and the global share markets are reacting accordingly.

The major risks to the broader economy will only be realised if Italy and Spain are dragged under by a Greek collapse. The two main Greek political parties have lost public support. As a result, many of the smaller parties are growing in strength and want to rewrite the deal with Europe. This may result eventually in Greece breaking away from the rest of Europe, defaulting entirely and returning to its own currency.

If Greece is to exit the Euro and return to the drachma share markets will in the first instance react badly however I believe this reaction will be short lived and more important to medium and long term outcomes will be how Europe and the rest of the world reacts to the fall out should it occur.

The complete undoing of the Euro Zone would be too expensive and would cause too many problems for Germany and the rest of the developed world and as a result when push eventually comes to shove I am confident that policy makers will do what it takes to prevent contagion of the Greek problem spreading further.

Greece needs to make spending cuts of around US$3bn in the next few weeks or it won’t get its next tranche of funding from Europe. If this doesn’t happen, the situation will become very interesting. This will be a major tragedy for Greece but has very little impact on the rest of the world or even Europe as long as this problem can be isolated from Italy and Spain. The likelihood of Greece leaving the Euro has been put by one leading economist late last week at 50%. If Greece exits all the attention will turn to Spain. That is where the contagion would need to be halted as the consensus view is that Spain is too big to fail.

As I have previously outlined many times over the last couple of years, the problems of the Euro Zone will need working out over time and we have expected continuing volatility as is playing out. European countries need growth and fiscal discipline. Labour costs in Italy and Spain need to come down and some banks will need more help restructuring and dealing with bad loan portfolios.

The Spanish Government however has shown it is willing and able to make big changes but it will need support from broader Europe and perhaps a softening of stance from Germany. If the Greek people vote to remain in the Euro at the re run of their election I expect we will see a significant rallying of markets. Markets are looking relatively cheap at the moment relative to earnings and this is no doubt because much risk is currently priced in. As these uncertainties resolve we are likely to see a repricing of markets and some good returns over the next couple of years.

The Green line on the chart below shows the price of the Australian market (ASX200) relative to returns the companies are generating and it is evident that the market is currently looking very good value relative to earnings.

The Australian share market rose about 8% over the first three months of this year. It has given back about 6% of that growth over the last couple of weeks. While this has provided good fodder for the financial journalists and some exciting headlines I’d suggest this is just another bump along the road to recovering from the sub-prime crisis. As a result I’d suggest sitting tight and be comfortable that well diversified portfolios are well placed to ride out these latest events and smoother roads are not too much further down the track.

My view to hold steady and remain invested here is also strongly coloured by the alternatives. Cash rates in Australia are being widely tipped to fall as low as 2%. This is likely to mean even high interest cash accounts and term deposits will be lucky to pay 3% returns in the near future. Bond returns have a few months to run while rates continue to fall but it is likely we will need to reduce fixed interest exposure in the coming months. Yields (income returns paid) will drop and capital risks for bonds become a problem when rates are at a low point in the cycle. The 6% plus franked returns available in the Australian share market in particular is looking relatively attractive. Our International shares holding are also somewhat protected against volatility through a recent reduction in currency hedging in our client portfolios. If risk and volatility increase it is likely the Aussie dollar will continue to fall and hence enhance returns on unhedged International holdings.

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Bronnie Abraham recently featured in the Financial Planning Magazine as the latest winner of the Gwen Fletcher Memorial Award for being the highest achiever in the CFP Certification Unit.
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